Italy's 5-Star and League put final touches to government deal

By Steve Scherer and Giuseppe Fonte

ROME (Reuters) - Italy's two anti-establishment parties met on Thursday to finalise a governing accord that would slash taxes, ramp up welfare spending and pose the biggest challenge to the European Union since Britain voted to leave the bloc two years ago.

The far-right League and the 5-Star Movement, which emerged as two of the biggest parties from an inconclusive election on March 4, have been discussing a common policy agenda to form a coalition government and end more than 10 weeks of stalemate.

According to a current draft agenda viewed by Reuters, the two sides would embark on policies that would breach EU rules on fiscal discipline: cutting taxes, increasing welfare payments for the poor and scrapping an unpopular pension reform.

 

The policies would cost many billions of euros and have spooked investors in Italian debt, shares and the euro. Italy is the euro zone's third-largest economy.

In a direct challenge to EU fiscal rules, the draft accord also wants the bloc to create fiscal headroom for spending by adjusting the formula used to calculate Italy's debt burden, which the rules say must be reduced.

In calculating debt as a proportion of gross domestic product -- Italy's ratio of 130 percent is second only to Greece in Europe -- the draft accord proposes discounting hundreds of billion euros in Italian debt purchased by the European Central Bank under the bank's quantitative easing (QE) programme.

News of the draft accord has caused concern in Brussels, where European Commission Vice President Valdis Dombrovskis told the EU parliament on Thursday that Italy's new government should stick to fiscal discipline and keep reducing public debt.

"This is our message to the new government. It's important to stay the course," Dombrovskis said.

Italy's borrowing costs have been rising as details of the accord emerge. The gap between the yields on Italy's benchmark bonds and safer German bonds was at its widest since early January as Italian 10-year bond yields were set for their biggest two-day jump since March last year.

FORGIVENESS

Outgoing Italian Prime Minister Paolo Gentiloni told a meeting of EU leaders in Bulgaria that he and other leaders were worried that fundamental issues such as the need to safeguard public accounts were now up for political discussion.

The draft pact proposed a new "universal income" for the poor costed at 17 billion euros, while it said a planned softening of an unpopular pension reform would cost 5 billion.

The plan promised to introduce a 15 percent flat tax rate for businesses and two tax rates of 15 and 20 percent for individuals -- a reform long promoted by the League. Economists say this would cost well over 50 billion euros in lost revenues.

There was still no word on the thorny issue of who would be prime minister. Neither League leader Matteo Salvini nor 5-Star leader Luigi Di Maio wants the other to get the job, but they have yet to find a mutually acceptable alternative figure.

President Sergio Mattarella, who has repeatedly stressed the importance of maintaining a strong, pro-European stance, may also be dismayed at any deal the League and 5-Star come up with.

Each party plans to consult its supporters over the weekend to see if they back the nascent government pact. The policy programme will probably be published on Thursday, 5-Star said.

(Additional reporting by Huw Jones and Crispian Balmer; Editing by Mark Bendeich and Peter Graff)